BREAKING DOWN 'Tax Accounting'

The purpose of accounting is to track funds associated with an individual or business.

Balance sheet items can be accounted for differently when preparing financial statements and tax payables. For example, companies can prepare their financial statements implementing the first-in-first-out (FIFO) method to record their inventory for financial purposes, yet they can implement the last-in-first-out (LIFO) approach for tax purposes. The latter procedure reduces the current year's taxes payable.

While accounting encompasses all financial transactions to some degree, tax accounting focuses solely on those transactions that affect an entities tax burden, and how those items relate to proper tax calculation and tax document preparation. Tax accounting is regulated by the Internal Revenue Service (IRS) to ensure that all associated tax laws are adhered to by tax accounting professionals and individual taxpayers. The IRS also requires the use of specific documents and forms to properly submit tax information as required by law.

Tax Accounting for an Individual

From the taxpayer sense, accounting would involve the tracking of all funds coming in and out of the persons' possession regardless of the purpose, including personal expenses that have no tax implications. Tax accounting focuses solely on items such as income, qualifying deductions, investment gains or losses, and other transactions that affect the individual’s tax burden. This limits the amount of information that is necessary for an individual to manage an annual tax return, and while a tax accountant can be used by an individual, it is not a legal requirement.

Tax Accounting for a Business

From a business perspective, more information must be analyzed as part of the tax accounting process. While the company’s earnings, or incoming funds, must be tracked just as they are for the individual, there is an additional level of complexity regarding any outgoing funds directed towards certain business obligations. This can include funds directed towards specific business expenses as well as funds directed towards shareholders.

While it is also not required that a business use a tax accountant to perform these duties, it is fairly common in larger organizations due to the complexity of the records involved.

Tax Accounting for a Tax-Exempt Organization

Even in instances where an organization is tax-exempt, tax accounting is necessary. This is due to the fact that all organizations must file annual returns. They must provide information regarding any incoming funds, such as grants or donations, as well as how the funds are used during the organization’s operation. This helps ensure that the organization adheres to all laws and regulations governing the proper operation of a tax-exempt entity.